White Papers

Is the IFRS 9 or CECL standard more volatile? Its all relative

Objective

In this study we compare the volatility of reported profit-and-loss (PnL) for credit portfolios when those are measured (accounted for) following respectively the IFRS 9 and CECL accounting standards.

The objective is to assess the impact of a key methodological difference between the two standards, the so-called Staging approach of IFRS 9. There are further explicit differences in the two standards. Importantly, given the standards are not prescriptive, it is very likely that there will be material differences in interpretation and implementation of the principles (for example on the nature and construction of scenarios). In this study we perform a controlled comparison adopting a ‘ceteris-paribus’ mentality: We assume that all other implementation details are similar and we focus on the impact of the Staging approach.

Credit Portfolio PnL volatility under IFRS 9 and CECL

Objective

We explore conceptually a selection of key structural drivers of profit-and-loss (PnL) volatility for credit portfolios when profitability is measured following the principles underpinning the new IFRS 9 / CECL standards

Methodology

We setup stylized calculations for a credit portfolio with the following main parameters and assumptions:

Credit Portfolio Management in the IFRS 9 / CECL and Stress Testing Era

The post-crisis world presents portfolio managers with the significant challenge to assimilate in day-to-day management the variety of conceptual frameworks now simultaneously applicable in the assessment of portfolio credit risk:

• The first major strand is the widespread application of regulatory stress testing methodologies in the estimation of regulatory risk capital requirements
• The second major strand is the introduction of new accounting standards (IFRS 9 / CECL) for the measurement and disclosure of expected credit losses While both Regulatory Stress Testing and IFRS 9 / CECL accounting require investment in analytic capabilities and provide unique new insights, both are aimed at satisfying evolving prudential or investor disclosure requirements. Neither is designed to help credit portfolio managers analyse and steer their portfolios in the bottom-up fashion that is an essential part their mandate.

The above developments are overlaid into pre-existing conceptual and practical frameworks such as

The new IFRS 9 financial reporting standard

IFRS 9 (and the closely related CECL) is a brand new financial reporting standard developed and approved by the International Accounting Standards Board (IASB).

Strictly speaking IFRS 9 concerns only the accounting and reporting of financial instruments (e.g. bank loans and similar credit products). Yet the introduction of the IFRS 9 standard has significant repercussions beyond financial reporting, and touches e.g., bank risk management as well. This is prompted by the fact that the framework requires embedding forward looking risk assessments in the measurement of the value of credit assets currently on the balance sheet.

What are European Safe Bonds?

While the creation of the eurozone was a landmark of the European integration process, the financial crisis highlighted that the eurozone remains an incomplete design which can lead to unpredictable and adverse situations in the event of a (the) next major crisis. One of the key such incompleteness features of the current eurozone architecture is that it does not have a truly risk-free (safe) euro debt instrument: one that continues being serviced (avoids a default event) at virtually any point in time and state of the world, no matter how severe.

Currently many countries are drowning in bad credits

This visualization from the World Bank shows the current distribution of non-performing loans (NPL’s in short) around the world, as fraction of the total outstanding loans:

From Big Data, to Linked Data and Linked Models

The big data problem:

As certainly as the sun will set today, the big data explosion will lead to a big clean-up mess.

How do we know? It is simply a case of history repeating. We only have to study the still smouldering last chapter of banking industry history. Currently banks are portrayed as something akin to the village idiot as far as technology adoption is concerned (and there is certainly a nugget of truth to this). Yet it is also true that banks, in many jurisdictions and across trading styles and business lines, have adopted data driven models already a long time ago. In fact, long enough ago that we have already observed how it call all ended pear shaped, Great Financial Crisis and all.

Open Risk White Paper 7: Risk Capital for Non-Performing Loans

We develop a conceptual framework for risk capital calculation for portfolios of non-performing loans. In general banking practice, loans that pass a threshold of delinquency are declared non-performing and are provisioned. Yet there is a residual risk that the provisioning is not sufficient. This risk must be covered by capital buffers. The literature for risk capital requirements for NPL portfolios is very limited, which implies that Stress Testing and Internal Capital Adequacy Assessment (ICAAP) requirements for non-performing loans are harder to meet. Our framework builds on tools used in portfolio credit risk modeling and provides a structured approach to address the risk profile that is specific to non-performing loans.

A stress testing methodology for analyzing FX lending risk. The methodology extends standard credit risk modelling tools to capture the increased risks of FX lending in a consistent way

Open Risk White Paper 6: Stress Testing Methodology for FX Lending

We develop a simple methodology for stress testing portfolios of credit instruments classified as foreign exchange lending. Loans whose repayment schedule is denominated in a currency other than that of the borrower’s domestic currency are commonly seen in many jurisdictions and have a risk profile that is considerably more complicated than domestic currency loans. Yet the literature for credit risk assessment and stress testing of portfolios of such loans is very limited, which means that Stress Testing and Internal Capital Adequacy Assessment (ICAAP) requirements are harder to meet. Our methodology builds on existing standard tools used in portfolio credit risk modeling and enables obtaining insights into the additional risk factors embedded in foreign currency lending.

Business Model Risk - The Forgotten Risk Type

Sustainable business models that demonstrate adequate profitability over long horizons are key to a healthy market economy. This applies to firms and organizations of any size and in any sector. But how do we determine what is sustainable and how can we tell a risky business structure from a stable one?

Open Risk White Paper 5: Identification Framework for Business Model Risks

We develop an analytical framework for the systematic identification of business model risks. The framework utilizes as a starting point a simplified business model schema known as the Business Model Canvas. We review each one of the elements of the schema in turn, identifying the main risk characteristics associated with each.

Back-to-basics is not salvation

It has become trendy since the financial crisis to be wearing an anti-complexity hat in matters concerning the shape of the financial system. This is an understandable reaction to the entangled constructions that had sprung to existence in the hyper-leveraged markets of the naughty noughts.

Open Risk White Paper 4: Open Risk Model Taxonomy

We develop a taxonomy for risk models that aims to support an open source risk models framework. The proposal builds on and extends some commonly used risk taxonomies within financial services firms but introduces some significant new elements. We first review the motivation for risk taxonomies, the concepts and tools that are involved and some weaknesses of current schemes. We try also to clarify the link between risk models and risk taxonomies.

Talk of unbundling the banks is all the rage these days (if we believe the chatter coming from fintech startups). Yet upon closer inspection one gets the feeling that these optimistic people might not necessarily know exactly what they are trying to unbundle, the true complexity of a medium-to-large bank, which in turn reflects, at least in part, the complexity of our modern Financial System .

If you work in financial risk management you will most likely recognize where the following sentence is coming from:

One of the most significant lessons learned from the global financial crisis that began in 2007 was that banks information technology (IT) and data architectures were inadequate to support the broad management of financial risks. This had severe consequences to the banks themselves and to the stability of the financial system as a whole

Open Risk White Paper 3: Introducing the Open Risk API

We develop a proposal for an open source application programming interface (API) that allows for the distributed development, deployment and use of financial risk models. The proposal aims to explore the following key question: how to integrate in a robust and trustworthy manner diverse risk modeling and risk data resources, contributed by multiple authors, using different technologies, and which very likely will evolve over time.

Open Risk White Paper 2: Confidence Capital: The Principle

We review the structure of economic capital frameworks commonly used within financial institutions and identify why the derived capital metrics do not explicitly address the needs for maintaining ongoing confidence on the soundness of the firm. In the follow-up to the financial crisis the need for more explicit such tests has been highlighted by regulatory stress testing methodologies.

The mystery of the collapsed cathedral

You walk to the center of an old city, and you see its glorious cathedral lying in ruins. What in the world has happened here? Your investigative instinct goes into overdrive. This is not supposed to happen. Not in peacetime anyway. How can it be that this magnificent edifice, after gracing the town’s central square for who knows how many centuries, is now little more than a rubble pile in the center of town?

Revisiting simple concentration indexes

Our white paper Revisiting simple concentration indexes reviews the definitions of widely used concentration metrics such as the concentration ratio, the HHI index and the Gini and clarify their meaning and relationships.